Why Andrew Ross Sorkin Is Wrong About Glass-Steagall

The book, "Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System - and Themselves," chronicled the 2008 financial crisis, the fall of Lehman, and captured the harrowing events which brought Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) to the brink of disaster. It also resulted in its author, Andrew Ross Sorkin, becoming canonized as the guru of all things Wall Street. In the article, "Reinstating an Old Rule is Not a Cure for Crisis," Sorkin explained the limits of the Glass-Steagall Act:

Glass-Steagall wouldn't have prevented the last financial crisis. And it probably wouldn't have prevented JPMorgan's (NYSE:JPM) $2 billion-plus trading loss. The loss occurred on the commercial side of the bank, not at the investment bank. But parts of the bet were made with synthetic credit derivatives ... The first domino to nearly topple over in the financial crisis was Bear Stearns, an investment bank that had nothing to do with commercial banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers; it too was an investment bank with no commercial banking business and therefore wouldn't have been covered by Glass-Steagall either. After them, Merrill Lynch was next - and yep, it too was an investment bank that had nothing to do with Glass-Steagall. Next in line was the American International Group (NYSE:AIG) an insurance company that was also unrelated to Glass-Steagall.

Sorkin correctly explains the "letter of the law" as it pertains to Glass-Steagall - the separation of commercial banking and investment banking. However, the article "Time to Revisit Glass-Steagall," explains the "spirit" behind it:

Congress and the Senate soon after enacted the Glass-Steagall Act which separated commercial banks and investment banks. The logic was that investment banks which engaged in riskier lines of business were also exposed to huge potential losses. That said, the government wanted to (i) protect bank depositors from potential volatile losses experienced by investment banks and (ii) to reduce the temptation of investment banks to bilk the public to recoup those losses.

The "spirit" of Glass Steagall was to reign in Wall Street risk-taking. And after Glass-Steagall was repealed, investment banks returned to the wanton speculation that defined the 1920s and '30s, and precluded the stock market crash and the Great Depression.

Speculation in MBS

According to "SHOCK EXCHANGE How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead," at the height of the financial crisis, selected investment banks like Bear Stearns, Lehman, Goldman, and Morgan Stanley held proprietary trading portfolios of $138 billion, $273 billion, $400 billion and $381 billion. Of those amounts, $46 billion, $97 billion, $361 billion and $331 billion, respectively, was invested in MBS and other fixed income securities. These fixed income securities were not held as inventory for "market-making" purposes, but were held as long-term investments. Therefore, these investment banks were effectively making loans in the secondary market - something the "spirit" of Glass-Steagall was against.

"Fobbing Off" Soured Investments Onto Unsuspecting Clients

And when those investments went bad, certain banks used their brokerage arms to fob them off on unsuspecting clients - exactly what the drafters of Glass-Steagall wanted to prevent. The article, SEC Accuses Goldman of Fraud, explains how Goldman knowingly sold soured MBS to clients while marketing them as "safe investments":

According to the complaint, Paulson paid Goldman Sachs approximately $15 million for structuring and marketing the security - ABACUS 2007-AC1 - in early 2007. Goldman let Paulson make bets against the residential real estate market, which the hedge fund believed was going to tank ... In layman's terms: Paulson played a significant role in picking which subprime mortgage-backed securities that would be used as the basis for ABACUS 2007-AC1, (ii) Paulson had an incentive to pick securities that would have tanked, since it was betting that the value of those securities would fall, and (iii) Goldman failed to disclose to investors Paulson's role in the portfolio selection process or its adverse economic interests.

JPMorgan with its Squared CDO 2007-1 and Citigroup (NYSE:C) via Class V Funding III fund, also fobbed off soured MBS onto unsuspecting clients, and were subsequently fined by the SEC. That said, I am bearish on the U.S. economy and the stock market as a whole. To get individuals to return to the market, regulators must restore a higher level of transparency. A return to Glass-Steagall would be a necessary step in repairing the public trust that investment banks and commercial banks destroyed leading up to, and during the financial crisis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.